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Turkey’s Continuing Interest Rate Dilemma

December 14, 2017

The Turkish Central Bank (CBRT) announced on December 14 its much-anticipated decision on interest rates by increasing the late liquidity window lending rate from 12.25 percent to 12.75 percent, while keeping overnight lending and one-week repo rates at 9.25 percent and 8 percent respectively. Although this was its first rate hike in eight months, many observers were disappointed as they had expected a bigger increase to curb the upward trend in inflation and stabilize the Turkish lira. Apparently, hints had been given by unnamed officials that this would be done. In fact, on December 5 the CBRT had itself stated that “communication policy will be used effectively as a supportive instrument in the upcoming period.”

The CBRT was clearly deterred by prevailing political realities and, accordingly, resorted once again to the subterfuge it has used since the beginning of 2017 to avoid raising the primary rate directly. As it explained on December 5, in order to “eliminate the negative effects” of volatility in foreign exchange markets following the global and geopolitical shocks in the second half of 2016 and “its negative impact on the inflation outlook,” the CBRT had closed the one-week repo rate at the beginning of the year and gradually reduced the overnight repo rate auctions, leaving banks only with the option of utilizing the late liquidity window.

Predictably, its decision failed to enhance its credibility in financial markets, as demonstrated by the immediate jump in the U.S. dollar (USD)/Turkish lira (TRY) rate from 3.83 to 3.89, and underlined the basic dilemma confronting the CBRT. It failed to satisfy investors, particularly those outside Turkey, who expected a bigger rate increase, as was shown by the steady fall in the USD/TRY rate from 3.98 to 3.81 in the weeks before the rate move. At the same time, it disappointed those, including President Recep Tayyip Erdogan, who have long argued that higher rates increased borrowing costs for individual consumers and companies and were therefore inimical to Turkey’s ambitious growth-focused policy. However, as Turkey lacks the domestic financial resources to sustain the high growth rate—11.1 percent in the third quarter—which depends to a great extent on easy credit, the country is reliant on the constant inflow of foreign funds, more recently short-term funds attracted by higher rates than longer-term foreign direct investment.

The 12.98 percent year-on-year inflation as of November is driven to a great extent by the fall in the Turkish lira of nearly 30 percent from early 2016 to November 2017. However, the CBRT has been unable to use the classic policy instrument of higher interest rates in the pursuit of its stated goal of curbing inflation as Erdogan continues to argue strongly that inflation is the product of higher interest rates. In his December 12 speech, in which he reiterated his opposition to rate hikes, Erdogan said “I see the attempts to justify the pressure of interest rate hike by means of short-term manipulations in economy as a futile attempt…We would be capable of undertaking significant projects with the money we are now spending to pay interest.”